The risks and rewards of SME investing: Not all small business investments are made equal

The emergence of crowdfunding has made SME investing – once a relatively hard-to-access asset class – now open to everyone. This is great news for small and mid-sized businesses and for investors alike. After all, small businesses are a key driver of economic growth, and the returns potential can be substantial.

However, as with any investment, it’s important to understand the risks and rewards before diving in.

What are the upsides?

Let’s start with the positives:

There’s the potential for impressive returns on investment, if the deal is structured and managed correctly. For instance, the latest British Venture Capital Association figures show that UK private equity (in other words investment in unquoted SMEs) has outperformed both the FTSE All-Share and UK pension fund assets over 10 years, returning 14.9 per cent per annum, compared to 7.6 per cent and 7.8 per cent respectively.

It can form an important part of a balanced portfolio – such assets tend to be longer-term investments and are therefore not subject to the same roller-coaster ride of volatility as quoted equities (which we’ve seen most obviously over the past week).

There are sometimes generous tax breaks. Investors in unquoted companies are now eligible for Entrepreneurs’ Relief, cutting their capital gains tax bill on disposal of these shares to just 10 per cent. Inheritance tax relief is available on unquoted shares held for two years too. There are also government schemes designed to encourage SME investment by providing additional income tax and capital gains tax breaks, such as the Enterprise Investment Scheme (EIS).

Then there’s the excitement factor. Many private investors get a buzz out of supporting small businesses’ progress and seeing them succeed. It is hugely rewarding to be part of that success.

Knowing the difference

Having said all that, it’s important to distinguish between different kinds of SME investments, as factors such as investment stage and deal type can significantly affect the risk-reward ratio.

Such opportunities essentially fall into two broad categories. One is venture capital, where investors back start-ups and early stage businesses to get their concept off the ground.

The second is investment in more established, later stage businesses requiring growth capital or funding for a change of ownership (for example, through a management buy-out).

Crowdfunding tends to focus mainly on venture capital, but funds such as Venture Capital Trusts (VCTs) can also be a good way in for retail investors (and providing tax breaks too), giving instant portfolio spread with experienced investment managers sourcing and managing deals. More experienced investors can access larger deals direct, either through their own networks or via professionally-managed syndicates which pool capital from multiple clients, acting as institutional investors on their behalf.

What about the downsides?

The key risks include:

The potential to lose the capital invested. By their very nature, unquoted businesses tend to be higher risk than more traditional quoted equities. As mentioned above, not all “private equity” categories are equal. While venture capital has the potential to deliver stellar returns, there’s also a far greater chance of failure than there is with later stage investments, where investee companies have established revenue streams and proven business models. It’s therefore important to have a broad spread of investments within a portfolio, especially at the early stage end.

Minority rights. Since private investors are usually minority shareholders, it’s vital to ensure that the right protections are in place to safeguard their interests – for example in the event of a subsequent funding round which could dilute their stake.

Illiquidity. Given that this kind of investing tends to be for the longer term (five year-plus exit plans are typical), investors should be aware that capital can stay locked up for quite some time, often with no right to drive an exit.

It’s important to ask whether returns can be delivered. Private investors need to be sure the management team have the drive and skills to deliver on growth ambitions to provide a return for shareholders, and aren’t simply running the business to provide a comfortable lifestyle for themselves. In-depth “due diligence” checks on the company and key staff at the outset are important here. Private investors also need to know who is driving the exit strategy – something which requires a huge amount of focus and expertise.

Investing in SMEs has much to offer private investors, but there are many pitfalls they need to be aware of. Spreading investments thinly across a selection of crowdfunding opportunities in small amounts is one way to do it but investors may also want to consider investing via a fund or in a professionally managed syndicate.

Focusing on thorough due diligence, sensible deal structuring and realistic exit plans are key. Get those things right, and the risks could be well rewarded.